The gas revolution

When Andrew Liveris took over as CEO of Dow Chemical at the end of 2004, the company was in the midst of a wrenching reorganization that saw it shed 7,000 jobs–14 percent of its workforce–and close 23 older chemical plants in this country. Looking ahead to a new product cycle in a fast-growing global marketplace, Liveris faced a stark choice: Should Dow invest in new capacity in the United States, or should he locate more facilities in emerging markets? One factor made expanding overseas much more attractive–not labor costs but the price of natural gas.

“One of the less appreciated facts of the U.S. energy marketplace is that the price of natural gas has been much more volatile than the price of oil over the last 15 years.” –Steven F. HaywardDow and several other industrial manufacturing sectors use natural gas as a basic feedstock for much of their product line, not primarily as an energy source. As such there are few substitutes or efficiency strategies the company could use. As Liveris told the Senate Energy and Natural Resources Committee in the fall of 2005, “This [natural gas] price of $14, simply put, renders the entire U.S. chemical industry uncompetitive. We simply cannot compete with the rest of the world at these prices. When faced with a choice of investing in the United States at $14 gas versus $2 to $3 elsewhere, how can I recommend investing here?” Not long after, Dow Chemical announced plans for a major expansion in Kuwait and Oman, both of which were able to guarantee long-term rock-bottom natural gas prices. Other chemical companies followed suit, and a sector that was once among the nation’s strongest export industries became a net importer. Between 1997 and 2005, overall industrial consumption of natural gas in the United States fell 22.4 percent.

One of the less appreciated facts of the U.S. energy marketplace is that the price of natural gas has been much more volatile than the price of oil over the last 15 years. Unlike oil, which trades at globally uniform prices, natural gas has always been a more locally traded commodity, with wide price differences from region to region. And in the middle years of the last decade, when the U.S. natural gas price spiked to $14 per thousand cubic feet, up from $2 or less for most of the 1990s, both Middle Eastern and Russian gas could be had much more cheaply–if you were located in their neighborhood.

Like domestic production of oil, U.S. production of natural gas had been relatively flat for years. All of the official public and private forecasts expected domestic gas production to decline, with the result that the United States, hitherto nearly self-sufficient in natural gas (we have been importing about 10 percent of our gas from Canada and Mexico), would have to import as much as 20 percent of our needs by the year 2020. Most of the new gas imports were expected to come from the Persian Gulf, extending American dependency on that politically sketchy region. The oil and gas industry argued that the only way to turn around our gas fortunes was to open up more areas for exploration and production, especially offshore on the continental shelf, but this ran into the same buzzsaw of political opposition that has hobbled domestic oil production.

Now, within an astonishingly short time, the entire picture has changed. In mid-December the Energy Information Administration released new estimates of U.S. natural gas showing proved reserves at their highest level since 1967, up 33 percent in the last three years and 62 percent over the last 10 years. Natural gas production in the United States in 2009 (21.6 trillion cubic feet) was the highest since 1973, even though demand was down on account of the recession. The Department of Energy now predicts gas reserves will grow by at least another 20 percent over the next decade, though a number of energy forecasters think reserves will grow by much more, securing a 100-year supply for our needs. Even as oil and gasoline prices rise again to uncomfortable levels, the price of natural gas has declined 80 percent from its mid-recession level in the summer of 2008, to about $4 per thousand cubic feet, and it is likely to stay at this level or perhaps fall further. Although price volatility may not be a thing of the past, it is unlikely we’ll see spikes to $14 again for a very, very long time.

How did this startling turnabout occur? The phrase suddenly in every newsroom copybook (the cover of Time magazine last week, a series in the New York Times last month) is “unconventional gas,” chiefly shale gas and coal-bed methane, produced through a technique known as hydraulic fracturing or “fracking.” Fracking involves sending high pressure fluid deep into wells to force cracks in the surrounding rock formations, which releases gas (and also oil where oil deposits are mixed in rock).

From the recent news reports you’d think shale gas and fracking had just been discovered, but neither is brand new. It has been known for decades that deep shale rock formations contain lots of natural gas, and oil drillers have employed fracking for years to enhance oil recovery. But fracking for shale gas was not economical until a second technology achieved major breakthroughs in the last decade and a half: directional drilling. It is possible today to drill several wells from a single platform in many different directions, often for several miles laterally, and navigational advances enable drillers to know their exact position down to a few inches from thousands of feet away. Combined with advances in underground geological surveying, directional drilling and fracking over the last decade have allowed us to tap into previously uneconomic shale gas deposits. At the present time shale gas accounts for about 20 percent of total U.S. gas production (up from 1 percent in 2000), but it is projected to account for nearly half of U.S. gas production by the year 2035.

One remarkable aspect of the shale gas revolution is that it was not the product of an energy policy edict from Washington, or the result of a bruising political battle to open up public lands and offshore waters for new exploration. Although the Halliburtons of the world are now big in the field, its pioneers were mostly smaller risk-taking entrepreneurs and technological innovators. George P. Mitchell, an independent producer based in Houston, is widely credited as being the prime mover in shale gas, pushing the idea against skeptics. The technology was mainly deployed on existing oil and gas leaseholds or on private land beyond the reach of bureaucrats (for the time being, anyway). That is why shale gas seemed to sneak up unannounced to the media and Beltway elites, even though people inside the gas industry realized several years ago what was rapidly taking place. Mitchell worked the Barnett shale formation near Dallas, but the biggest shale gas “play” is the Marcellus–a massive deep shale formation stretching from West Virginia through upstate New York.

Now that shale gas is front-page news, everyone wants a piece of the action. Environmentalists, who have supported natural gas as a “bridge fuel” to kill coal, are starting to turn against gas now that it looks more abundant. Regulators want to regulate it; state legislators want to tax it more. And politicians are eager to “help” the market decide how best to use this newfound bounty, which is music to the gas industry’s ears, as they fear a glut might collapse prices and do to their industry what the collapse in oil prices in 1986 did to the small producers in the oil patch. In other words, the one thing that might disrupt this amazing success story has arrived on the scene: politics.

The shale gas revolution presents two main issues. The first concerns fracking, which is currently unregulated or lightly regulated by state and local governments. Fracking is currently exempt from some sections of the Clean Water Act and the Safe Drinking Water Act, though it is subject to all of the wastewater and hazardous material rules and regulations. Fracking fluids, once they have done their work loosening the gas, contain some toxic chemicals (and can pick up low levels of radiation from deep underground). Environmentalists are raising a predictable hue and cry about threats to groundwater from well casing leaks or from water that returns to the surface. The environmental crusade against fracking has its own Inconvenient Truth-style documentary, Gasland, by Pennsylvania filmmaker Josh Fox, which was nominated for best documentary at the Academy Awards and aired on HBO.

Gasland features dramatic footage of gas-infused well water that can be ignited at a kitchen tap, though it is not established that this is the result of nearby shale gas drilling. Hitting pockets of gas has been a well-known phenomena in shallow water wells in parts of Pennsylvania for decades. Most shale gas fracking is conducted as far as 5,000 feet underground, thousands of feet below the aquifer and beneath impermeable rock layers that separate it from drinking water. Still, spills and leaking well casings near the surface have caused some localized water pollution problems, providing just enough traction for environmentalist complaints. The EPA has launched a major study of fracking that is expected to report findings in 2014, and New York’s outgoing governor David Paterson imposed a moratorium on new gas drilling last year in response to claims that fracking threatened groundwater, even though New York’s state geologist concluded fracking presented a low risk to the state’s groundwater.

Environmentalists used to love natural gas–so long as it was expensive and used in part as a backstop for intermittent wind and solar power. Now that it is suddenly cheap and practical for baseload generation, environmentalists are changing their minds. Politico’s Bob King noted this about-face in a mid-February story, “Greens Sour on Natural Gas.” The Environmental Defense Fund, ProPublica, and the Sierra Club are suddenly voicing opposition to the expansion of natural gas use. King quoted Sierra Club chairman Carl Pope calling for phasing out natural gas use in the United States entirely by the year 2050, and Sierra’s deputy executive director Bruce Hamilton said, “We want people to know that natural gas is not a clean fuel.” As recently as a December appearance with me on CNBC, Hamilton endorsed using “clean” natural gas “for a very long time.” You might call this the theorem of environmental duplicity: namely, there is no form of “clean” or “alternative” energy that environmentalists won’t decide to oppose if it becomes practical and affordable on a large scale.

From the standpoint of the increasingly desperate and forlorn climate campaign, environmentalists have a point. Natural gas has long been regarded as the cleanest of the fossil fuels because it is much lower in conventional air pollutants (that is, the emissions that cause ozone, particulates, and carbon monoxide) than coal or oil. But it is still a prodigious producer of carbon dioxide; climate change orthodoxy calls for reducing CO2 emissions to almost 1 billion tons by the year 2050, yet carbon dioxide emissions from current levels of natural gas use are 1.2 billion tons a year. There is no way to reach the targets of climate orthodoxy if we expand our use of natural gas.

Still, it may be a mistake to adopt a dirigiste policy of pushing natural gas use in the electric power sector, because coal remains abundant and cheap, and neither climate hysteria nor conventional air pollution concerns are compelling enough reasons to suppress coal power deliberately. (Conventional air pollutants and mercury emissions from coal plants are falling steadily, and will continue to do so even without a new suite of EPA regulations.) Substituting natural gas for coal power plants would not reduce our imports of foreign oil by a single barrel. But adopting natural gas as a transportation fuel in our car and truck fleet would, if done on a large scale, and this is the most tantalizing prospect.

T. Boone Pickens has been pushing this idea for the last two years, arguing that we should start with the trucking fleet. But the conversion costs are high. It costs about $50,000 or more to convert a diesel truck to run on compressed natural gas, and natural gas-powered autos would be considerably more expensive than gasoline-powered autos. The one commercial natural gas car currently available, a Honda Civic, costs about $10,000 more than a gasoline engine Civic. Natural gas vehicles would require a large compressed gas infrastructure that does not currently exist. Pickens and other natural gas transportation enthusiasts are lobbying for tax credits for truck fleet conversions and filling station gas compression upgrades–another subsidy the federal budget doesn’t need right now. But federal subsidies may not be necessary. If diesel reaches $5 a gallon, the unsubsidized payback period for converting a high-mileage long-haul truck would be two years or less at current natural gas prices. That’s why UPS is starting to expand its fleet of natural gas trucks. For comparatively low-mileage passenger cars, the price of gasoline would have to be much higher than it is today for gas conversion to look attractive, somewhere in the neighborhood of $8 or $9 a gallon.

With all of the emphasis–and confusion–in the automotive industry about whether to develop hybrid-electric cars or other power sources, policymakers ought to tread carefully before piling on a new market-distorting tax credit or subsidy. Furthermore, natural gas can be converted to liquid fuels, especially methanol, that can be used in current gasoline-powered cars for a minimal extra conversion cost. At current natural gas prices, methanol can be produced at a cost of about $1.30 a gallon, though methanol has a lower energy content than gasoline, so the equivalent gasoline price would be closer to about $1.60 a gallon–attractive at current oil prices, but not if oil drops again to 2009 levels.

Finally, it is not a slam dunk that newly abundant natural gas supplies should be used primarily for new energy production. Current low prices are inducing the chemical industry to begin looking to our shores again for expansion. Two weeks ago CP Chem, a joint venture of Chevron and ConocoPhillips, announced that it is considering a major expansion at a Gulf Coast facility that would utilize shale gas, a development Chemical Week called “the most significant yet related to the improved cost position of U.S. petro-chemicals.” The chief fear of the chemical industry is that the price volatility that drove them overseas in the last decade might not be over. The chemical industry, like electric utilities, has been bit before by confident assurances that cheap gas was here to stay.

There is good reason for that concern. The urge for politicians and collaborating interest groups to meddle in the natural gas success story is irresistible, but all options for gas share one key assumption that should not go unchallenged: that the shale gas revolution will continue uninterrupted, thereby guaranteeing stable low prices. Although this appears probable at the moment, two aspects of shale gas production have escaped notice in the recent lavish media attention. First, its production costs–the “hurdle rate” as it is called in the trade–can be highly variable and site specific. Although hurdle rates are proprietary information from site to site and company to company, some shale gas plays such as the Haynesville-Bossier that straddles the Texas-Louisiana border are said to have production costs as high as $4 per thousand cubic feet, which is only slightly above the current market price. Hence in recent months, many drilling rigs have been pulling out of the Haynesville-Bossier and moving back to straight oil exploration in other parts of Texas. By contrast, the hurdle rate for Marcellus gas wells is said to be as low as 60 cents per thousand cubic feet in some cases, making the Marcellus play very profitable even if prices fall substantially below current levels.

The second factor is that shale gas wells have a much faster production decline curve than conventional gas wells; in other words, shale wells run out of gas sooner, requiring new wells to be drilled on a constant basis. New regulations that slow or make more expensive the replenishment of depleting wells, or a gas glut that collapses prices and idles drilling capacity, could set off a fresh round of price volatility and scramble everyone’s calculations. It would be best if politicians left well enough alone and allowed the marketplace to compete over the uses of natural gas, but politics and energy have always mixed like gin-ethanol and tonic, so don’t count on it.